TOPIC: EVALUATING FINANCIAL PERFORMANCE

OBJECTIVES:

•DETERMINE HOW THE FIRM HAS PERFORMED OVER TIME AND RELATIVE TO OTHER FIRMS.

•EXPLORE METHODS TO IMPROVE FINANCIAL PERFORMANCE.

•ESTABLISH THE STARTING POINT FOR MAKING FINANCIAL PROJECTIONS.

RW Melicher IBanking 2013 1

I. FINANCIAL MODELS AND RATIOS

• FINANCIAL MODELS CONSIST OF TWO OR MORE INTERACTING RATIOS

• FINANCIAL MODELS ALLOW THE SIMULTANEOUS EXAMINATION OF TWO OR MORE FINANCIAL DIMENSIONS (E.G., PROFITABILITY, ASSET UTILIZATION, FINANCIAL LEVERAGE, ETC.)

• FINANCIAL RATIOS PROVIDE THE BASIS FOR CONDUCTING COMPARABLE COMPANIES VALUATION ANALYSIS

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A. RETURN ON ASSETS MODEL

OPERATING PERFORMANCE IS COMPOSED OF:

1.PROFIT MARGIN (PM) = NET PROFIT/NET SALES

2.ASSET TURNOVER OR UTILIZATION (ATO) = NET SALES/TOTAL ASSETS

•RETURN ON ASSETS (ROA) FINANCIAL MODEL = PM X ATO

•ROA = NET PROFIT/NET SALES X NET SALES/TOTAL ASSETS = NET PROFIT/TOTAL ASSETS

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B. RETURN ON EQUITY MODEL

RETURN ON EQUITY (ROE) FINANCIAL MODEL = 1. PROFIT MARGIN (PM) X2. ASSET TURNOVER (ATO) X 3. EQUITY MULTIPLIER (EM) [WHERE EM = TOTAL ASSETS/COMMON EQUITY]

ROE = NET INCOME/NET SALES X NET SALES/TOTAL ASSETS X NET INCOME/COMMON EQUITY, OR NET INCOME/COMMON EQUITY

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C. CONDUCTING RATIO ANALYSIS

TYPES OF FINANCIAL RATIOS:

1. LIQUIDITY

2. PROFIT MARGIN

3. ASSET TURNOVER (UTILIZATION)

4. FINANCIAL LEVERAGE

5. PROFITABILITY (RETURNS)

6. MARKET VALUE-BASED

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MARKET VALUE-BASED RATIOS:

1. MARKET-TO-BOOK VALUE RATIO: (STOCK PRICE X NUMBER OF SHARES

OUTSTANDING)/(BOOK VALUE OF COMMON EQUITY) 2. PRICE-EARNINGS (P/E) MULTIPLE: STOCK PRICE/EARNINGS PER SHARE (EPS)3. PEG RATIO: (PRICE/EARNINGS MULTIPLE)/(EARNINGS GROWTH FORECAST) [NOTE: MARKET VALUE IS ALSO REFERRED TO AS THEMARKET CAPITALIZATION VALUE OR MARKET “CAP”]

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D. METHODS FOR IMPROVING FINANCIAL PERFORMANCE

• OPERATIONS RESTRUCTURING:

IMPROVE GROSS PROFIT AND/OR OPERATING PROFIT MARGINS

• ASSET RESTRUCTURING:

IMPROVE UTILIZATION OF CURRENT ASSETS (WORKING CAPITAL)

AND/OR FIXED ASSETS

• FINANCIAL RESTRUCTURING:

LOWER COST OF FINANCING THROUGH: AN EFFICIENT MIX OF DEBT

AND EQUITY FUNDS, AND COST OF CAPITAL TIMING OPPORTUNITIES 10

II. ADDITIONAL FINANCIAL ANALYSIS TOOLS

• INTERPRETING THE STATEMENT OF CASH FLOWS

• EXAMINING COMMON SIZE FINANCIAL STATEMENTS

• MANAGING THE CASH CONVERSION CYCLE 11

A. STATEMENT OF CASH FLOWS ANALYSIS

• THREE AREAS:

1. CASH FLOW FROM OPERATING ACTIVITIES

2. CASH FLOW FROM INVESTING ACTIVITIES

3. CASH FLOW FROM FINANCING ACTIVITIES

• NET CASH BURN VERSUS NET CASH BUILD:SUM OF OPERATING AND INVESTING ACTIVITIES—IF NEGATIVE, CASH BURN OCCURRED, AND IF POSITIVE, CASH BUILD OCCURRED

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B. COMMON-SIZED STATEMENT ANALYSIS

• COMMON SIZE INCOME STATEMENTS:EACH ITEM IS EXPRESSED AS A PERCENTAGE OF NET SALES

• COMMON SIZE BALANCE SHEETS:EACH ITEM IS EXPRESSED AS A PERCENTAGE OF TOTAL ASSETS

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C. MANAGING INVESTMENT IN WORKING CAPITAL

• CASH CONVERSION CYCLE (CCC):1. INVENTORY CONVERSION PERIOD (ICP)

2. RECEIVABLES COLLECTION PERIOD (RCP)

3. PAYABLES DEFERRAL PERIOD (PDP)

4. CCC = ICP + RCP – PDP

[NOTE: THE SHORTER THE CYCLE THE LOWER THE INVESTMENT IN

NET WORKING CAPITAL.]

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CCC COMPONENT CALCULATIONS:

1. INVENTORY CONVERSION PERIOD: INVENTORY/(SALES/365) OR, INVENTORY/(COGS/365)

2. RECEIVABLES COLLECTION PERIOD: RECEIVABLES/(SALES/365)

3. PAYABLES DEFERRAL PERIOD: PAYABLES/(COGS/365)

[NOTE: COGS = COST OF GOODS SOLD]

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III. SELECTED SOURCES FOR FINANCIAL INFORMATION

• RISK MANAGEMENT ASSOCIATION, ANNUAL STATEMENT STUDIES (FORMERLY ROBERT MORRIS ASSOCIATES)

• VALUE LINE INVESTMENT SURVEY (AVAILABLE ONLINE IN SOME LIBRARIES)

• DUN & BRADSTREET, INDUSTRY NORMS & KEY BUSINESS RATIOS

• ALMANAC OF BUSINESS AND INDUSTRIAL FINANCIAL RATIOS

• MERGENT INDUSTRIAL MANUAL (FORMERLY MOODY’S)

• HTTP://FINANCE.YAHOO.COM

• HTTP://WWW.HOOVERS.COM

• HTTP://MONEY.CNN.COM 17

FINANCIAL INFORMATION SOURCES (CONTINUED):

• HTTP://WWW.SEC.GOV [EDGAR DATABASE]

• HTTP://TOBSEFIN.SWLEARNING.COM [THOMSON ONE]

• HTTP://WWW.REUTERS.COM

• HTTP://WWW.BLOOMBERG.COM

• HTTP://WWW.TREASURY.GOV

• HTTP://WWW.FEDERALRESERVE.GOV

• HTTP://WWW.STLOUISFED.ORG [FRED DATABASE]

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